Certain exchanges of property are not taxable. This means any gain from the exchange is not recognized, and any loss cannot be deducted. Your gain or loss will not be recognized until you sell or otherwise dispose of the property you receive.

Like-Kind Exchanges

The exchange of property for the same kind of property is the most common type of nontaxable exchange. To be a like-kind exchange, the property traded and the property received must be both of the following.

• Qualifying property.
• Like-kind property.

These two requirements are discussed later.

Additional requirements apply to exchanges in which the property received is not received immediately upon the transfer of the property given up. See Deferred Exchanges, later.

If the like-kind exchange involves the receipt of money or unlike property or the assumption of your liabilities, you may have to recognize gain. See Partially Nontaxable Exchanges, later.

Multiple-party transactions. The like-kind exchange rules also apply to property exchanges that involve three- and four-party transactions. Any part of these multiple-party transactions can qualify as a like-kind exchange if it meets all the requirements described in this section.

Receipt of title from third party. If you receive property in a like-kind exchange and the other party who transfers the property to you does not give you the title, but a third party does, you can still treat this transaction as a like-kind exchange if it meets all the requirements.

Basis of property received. If you acquire property in a like-kind exchange, the basis of that property is the same as the basis of the property you transferred.

For the basis of property received in an exchange that is only partially nontaxable, see Partially Nontaxable Exchanges, later.

Example. You exchanged real estate held for investment with an adjusted basis of $25,000 for other real estate held for investment. The fair market value of both properties is $50,000. The basis of your new property is the same as the basis of the old ($25,000).

Money paid. If, in addition to giving up like-kind property, you pay money in a like-kind exchange, you still have no recognized gain or loss. The basis of the property received is the basis of the property given up, increased by the money paid.

Example. Bill Smith trades an old cab for a new one. The new cab costs $30,000. He is allowed $8,000 for the old cab and pays $22,000 cash. He has no recognized gain or loss on the transaction regardless of the adjusted basis of his old cab. If Bill sold the old cab to a third party for $8,000 and bought a new one, he would have a recognized gain or loss on the sale of his old cab equal to the difference between the amount realized and the adjusted basis of the old cab.

Sale and purchase. If you sell property and buy similar property in two mutually dependent transactions, you may have to treat the sale and purchase as a single nontaxable exchange.

Example. You used your car in your business for 2 years. Its adjusted basis is $3,500 and its trade-in value is $4,500. You are interested in a new car that costs $20,000. Ordinarily, you would trade your old car for the new one and pay the dealer $15,500. Your basis for depreciation of the new car would then be $19,000 ($15,500 plus $3,500 adjusted basis of the old car).

Because you want your new car to have a larger basis for depreciation, you arrange to sell your old car to the dealer for $4,500. You then buy the new one for $20,000 from the same dealer. However, you are treated as having exchanged your old car for the new one because the sale and purchase are reciprocal and mutually dependent. Your basis for depreciation for the new car is $19,000, the same as if you traded the old car.

Reporting the exchange. Report the exchange of like-kind property, even though no gain or loss is recognized, on Form 8824. The instructions for the form explain how to report the details of the exchange.

If you have any recognized gain because you received money or unlike property, report it on Schedule D (Form 1040) or Form 4797, whichever applies. See chapter 4. You may have to report the recognized gain as ordinary income from depreciation. See Like-Kind Exchanges and Involuntary Conversions in chapter 3.

Exchange expenses. Exchange expenses are generally the closing costs you pay. They include such items as brokerage commissions, attorney fees, and deed preparation fees. Subtract these expenses from the consideration received to figure the amount realized on the exchange. Also add them to the basis of the like-kind property received. If you receive cash or unlike property in addition to the like-kind property and realize a gain on the exchange, subtract the expenses from the cash or fair market value of the unlike property. Then use the net amount to figure the recognized gain. See Partially Nontaxable Exchanges, later.

Qualifying Property

In a like-kind exchange, both the property you give up and the property you receive must be held by you for investment or for productive use in your trade or business. Machinery, buildings, land, trucks, and rental houses are examples of property that may qualify.

The rules for like-kind exchanges do not apply to exchanges of the following property.

• Property you use for personal purposes, such as your home and your family car.
• Stock in trade or other property held primarily for sale, such as inventories, raw materials, and real estate held by dealers.
• Stocks, bonds, notes, or other securities or evidences of indebtedness, such as accounts receivable.
• Partnership interests.
• Certificates of trust or beneficial interest.
• Choses in action.

However, you might have a nontaxable exchange under other rules. See Other Nontaxable Exchanges, later.

An exchange of the assets of a business for the assets of a similar business cannot be treated as an exchange of one property for another property. Whether you engaged in a like-kind exchange depends on an analysis of each asset involved in the exchange. However, see Multiple Property Exchanges, later.

Like-Kind Property

There must be an exchange of like-kind property. Like-kind properties are properties of the same nature or character, even if they differ in grade or quality. The exchange of real estate for real estate and the exchange of personal property for similar personal property are exchanges of like-kind property. For example, the trade of land improved with an apartment house for land improved with a store building, or a panel truck for a pickup truck, is a like-kind exchange.

An exchange of personal property for real property does not qualify as a like-kind exchange. For example, an exchange of a piece of machinery for a store building does not qualify. Nor does the exchange of livestock of different sexes qualify.

Real property. An exchange of city property for farm property, or improved property for unimproved property, is a like-kind exchange.

The exchange of real estate you own for a real estate lease that runs 30 years or longer is a like-kind exchange. However, not all exchanges of interests in real property qualify. The exchange of a life estate expected to last less than 30 years for a remainder interest is not a like-kind exchange.

An exchange of a remainder interest in real estate for a remainder interest in other real estate is a like-kind exchange if the nature or character of the two property interests is the same.

Foreign real property exchanges. Real property located in the United States and real property located outside the United States are not considered like-kind property under the like-kind exchange rules. If you exchange foreign real property for property located in the United States, your gain or loss on the exchange is recognized. Foreign real property is real property not located in a state or the District of Columbia.

This foreign real property exchange rule does not apply to the replacement of condemned real property. Foreign and U.S. real property can still be considered like-kind property under the rules for replacing condemned property to postpone reporting gain on the condemnation. See Postponement of Gain under Involuntary Conversions, earlier.

Personal property. Depreciable tangible personal property can be either "like kind" or "like class" to qualify for nonrecognition treatment. Like-class properties are depreciable tangible personal properties within the same General Asset Class or Product Class. Property classified in any General Asset Class may not be classified within a Product Class.

General Asset Classes. General Asset Classes describe the types of property frequently used in many businesses. They include the following property.

1. Office furniture, fixtures, and equipment (asset class 00.11).
2. Information systems, such as computers and peripheral equipment (asset class 00.12).
3. Data handling equipment except computers (asset class 00.13).
4. Airplanes (airframes and engines), except planes used in commercial or contract carrying of passengers or freight, and all helicopters (airframes and engines) (asset class 00.21).
5. Automobiles and taxis (asset class 00.22).
6. Buses (asset class 00.23).
7. Light general purpose trucks (asset class 00.241).
8. Heavy general purpose trucks (asset class 00.242).
9. Railroad cars and locomotives except those owned by railroad transportation companies (asset class 00.25).
10. Tractor units for use over the road (asset class 00.26).
11. Trailers and trailer-mounted containers (asset class 00.27).
12. Vessels, barges, tugs, and similar water-transportation equipment, except those used in marine construction (asset class 00.28).
13. Industrial steam and electric generation or distribution systems (asset class 00.4).

Product Classes. Product Classes include property listed in a 4-digit product class (except any ending in "9," a miscellaneous category) in Division D of the Standard Industrial Classification codes of the Executive Office of the President, Office of Management and Budget, Standard Industrial Classification Manual (SIC Manual). Copies of the manual may be obtained from the National Technical Information Service, an agency of the U.S. Department of Commerce. To order the manual, call the National Technical Information Service at 1-800-553-NTIS (1-800-553-6847). The cost of the manual is $36 and the order number is PB87-100012.

Example 1. You transfer a personal computer used in your business for a printer to be used in your business. The properties exchanged are within the same General Asset Class and are of a like class.

Example 2. Trena transfers a grader to Ron in exchange for a scraper. Both are used in a business. Neither property is within any of the General Asset Classes. Both properties, however, are within the same Product Class and are of a like class.

Intangible personal property and nondepreciable personal property. If you exchange intangible personal property or nondepreciable personal property for like-kind property, no gain or loss is recognized on the exchange. (There are no like classes for these properties.) Whether intangible personal property, such as a patent or copyright, is of a like kind to other intangible personal property generally depends on the nature or character of the rights involved. It also depends on the nature or character of the underlying property to which those rights relate.

Example. The exchange of a copyright on a novel for a copyright on a different novel can qualify as a like-kind exchange. However, the exchange of a copyright on a novel for a copyright on a song is not a like-kind exchange.

Goodwill and going concern. The exchange of the goodwill or going concern value of a business for the goodwill or going concern value of another business is not a like-kind exchange.

Foreign personal property exchanges. Personal property used predominantly in the United States and personal property used predominantly outside the United States are not like-kind property under the like-kind exchange rules. If you exchange property used predominantly in the United States for property used predominantly outside the United States, your gain or loss on the exchange is recognized.

This rule does not apply to any transfer under a written binding contract in effect on June 8, 1997, or at any time thereafter before the disposition of property. A contract will not fail to be binding solely because it provides for a sale in lieu of an exchange or the property to be acquired as replacement property was not identified under that contract before June 9, 1997.

Predominant use. You determine the predominant use of property you gave up based on where that property was used during the 2-year period ending on the date you gave it up. You determine the predominant use of the property you acquired based on where that property was used during the 2-year period beginning on the date you acquired it.

But if you held either property less than 2 years, determine its predominant use based on where that property was used only during the period of time you (or a related person) held it. This does not apply if the exchange is part of a transaction (or series of transactions) structured to avoid having to treat property as unlike property under this rule.

However, you must treat property as used predominantly in the United States if it is used outside the United States but, under section 168(g)(4) of the Internal Revenue Code, is eligible for accelerated depreciation as though used in the United States.

Deferred Exchange

A deferred exchange is one in which you transfer property you use in business or hold for investment and later you receive like-kind property you will use in business or hold for investment. (The property you receive is replacement property.) The transaction must be an exchange (that is, property for property) rather than a transfer of property for money used to buy replacement property.

If, before you receive the replacement property, you actually or constructively receive money or unlike property in full payment for the property you transfer, the transaction will be treated as a sale rather than a deferred exchange. In that case, you must recognize gain or loss on the transaction, even if you later receive the replacement property. (It would be treated as if you bought it.)

You constructively receive money or unlike property when the money or property is credited to your account or made available to you. You also constructively receive money or unlike property when any limits or restrictions on it expire or are waived.

Whether you actually or constructively receive money or unlike property, however, is determined without regard to certain arrangements you make to ensure that the other party carries out its obligation to transfer the replacement property to you. For example, if you have that obligation secured by a mortgage or by cash or its equivalent held in a qualified escrow account or qualified trust, that arrangement will be disregarded in determining whether you actually or constructively receive money or unlike property. For more information, see section 1.1031(k)-1(g) of the regulations. Also, see Like-Kind Exchanges Using Qualified Intermediaries, later.

Identification requirement. You must identify the property to be received within 45 days after the date you transfer the property given up in the exchange. Any property received during that time is considered to have been identified.

If you transfer more than one property (as part of the same transaction) and the properties are transferred on different dates, the identification period and the receipt period begin on the date of the earliest transfer.

Identifying replacement property. You must identify the replacement property in a signed written document and deliver it to the other person involved in the exchange. You must clearly describe the replacement property in the written document. For example, use the legal description or street address for real property and the make, model, and year for a car. In the same manner, you can cancel an identification of replacement property at any time before the end of the identification period.

Identifying alternative and multiple properties. You can identify more than one replacement property. Regardless of the number of properties you give up, the maximum number of replacement properties you can identify is the larger of the following.

• Three.
• Any number of properties whose total fair market value (FMV) at the end of the identification period is not more than double the total fair market value, on the date of transfer, of all properties you give up.

If, as of the end of the identification period, you have identified more properties than permitted under this rule, the only property that will be considered identified is:

• Any replacement property you received before the end of the identification period, and
• Any replacement property identified before the end of the identification period and received before the end of the receipt period, but only if the fair market value of the property is at least 95% of the total fair market value of all identified replacement properties. (Do not include any you canceled.) Fair market value is determined on the earlier of the date you received the property or the last day of the receipt period.

Disregard incidental property. Do not treat property incidental to a larger item of property as separate from the larger item when you identify replacement property. Property is incidental if it meets both the following tests.

• It is typically transferred with the larger item.
• The total fair market value of all the incidental property is not more than 15% of the total fair market value of the larger item of property.

Replacement property to be produced. Gain or loss from a deferred exchange can qualify for nonrecognition even if the replacement property is not in existence or is being produced at the time you identify it as replacement property. If you need to know the fair market value of the replacement property to identify it, estimate its fair market value as of the date you expect to receive it.

To determine whether the replacement property you received qualifies as like kind by being substantially the same as the property you identified, do not take into account any variations due to usual production changes. Substantial changes in the property to be produced, however, will disqualify it as like-kind property.

If your identified replacement property is personal property to be produced, it must be completed by the date you receive it to qualify as like-kind property.

If your identified replacement property is real property to be produced and it is not completed by the date you receive the property, it may still qualify as like-kind property. It will qualify as like-kind property only if, had it been completed on time, the property you received would have been considered to be substantially the same as the property you identified. It is considered to be substantially the same only to the extent the property received is considered real property under local law. However, any additional production on the replacement property after you receive it does not qualify as like-kind property. (To this extent, the transaction is treated as a taxable exchange of property for services.)

Receipt requirement. The property must be received by the earlier of the following dates.

• The 180th day after the date on which you transfer the property given up in the exchange.
• The due date, including extensions, for your tax return for the tax year in which the transfer of the property given up occurs.

You must receive substantially the same property that met the identification requirement, discussed earlier.

Like-Kind Exchanges Using Qualified Intermediaries

If you transfer property through a qualified intermediary, the transfer of the property given up and receipt of like-kind property is treated as an exchange. This rule applies even if you receive money or other property directly from a party to the transaction other than the qualified intermediary.

A qualified intermediary is a person who enters into a written exchange agreement with you to acquire and transfer the property you give up and to acquire the replacement property and transfer it to you. This agreement must expressly limit your rights to receive, pledge, borrow, or otherwise obtain the benefits of money or other property held by the qualified intermediary.

A qualified intermediary cannot be either of the following.

• Your agent at the time of the transaction. This includes a person who has been your employee, attorney, accountant, investment banker or broker, or real estate agent or broker within the 2-year period before the transfer of property you give up.
• A person who is related to you or your agent under the rules discussed in chapter 2 under Nondeductible Loss, substituting "10%" for "50%."

An intermediary is treated as acquiring and transferring property if all the following requirements are met.

1. The intermediary acquires and transfers legal title to the property.
2. The intermediary enters into an agreement with a person other than you for the transfer to that person of the property you give up and that property is transferred to that person.
3. The intermediary enters into an agreement with the owner of the replacement property for the transfer of that property and the replacement property is transferred to you.

An intermediary is treated as entering into an agreement if the rights of a party to the agreement are assigned to the intermediary and all parties to that agreement are notified in writing of the assignment by the date of the relevant transfer of property.

Like-Kind Exchanges Using Qualified Exchange Accommodation Arrangements (QEAAs)

The like-kind exchange rules generally do not apply to an exchange in which you acquire replacement property (new property) before you transfer relinquished property (property you give up). However, if you use a qualified exchange accommodation arrangement (QEAA), the transfer may qualify as a like-kind exchange.

Under a QEAA, either the replacement property or the relinquished property is transferred to an exchange accommodation titleholder (EAT), discussed later, who is treated as the beneficial owner of the property for federal income tax purposes. If the property is held in a QEAA, the IRS will accept the qualification of property as either replacement property or relinquished property and the treatment of an EAT as the beneficial owner of the property for federal income tax purposes.

Requirements for a QEAA. Property is held in a QEAA only if all the following requirements are met.

• You have a written agreement.
• The time limits for identifying and transferring the property are met.
• The qualified indications of ownership of property are transferred to an EAT.

Written agreement. Under a QEAA, you and the EAT must enter into a written agreement no later than 5 business days after the qualified indications of ownership (discussed later) are transferred to the EAT. The agreement must provide all the following.

• The EAT is holding the property for your benefit in order to facilitate an exchange under the like-kind exchange rules and Revenue Procedure 2000-37.
• You and the EAT agree to report the acquisition, holding, and disposition of the property on your federal income tax returns in a manner consistent with the agreement.
• The EAT will be treated as the beneficial owner of the property for all federal income tax purposes.

Property can be treated as being held in a QEAA even if the accounting, regulatory, or state, local, or foreign tax treatment of the arrangement between you and the EAT is different from the treatment required by the list above.

Bona fide intent. When the qualified indications of ownership of the property are transferred to the EAT, it must be your bona fide intent that the property held by the EAT represents either replacement property or relinquished property in an exchange intended to qualify for nonrecognition of gain (in whole or in part) or loss under the like-kind exchange rules.

Time limits for identifying and transferring property. Under a QEAA, the following time limits for identifying and transferring the property must be met.

1. No later than 45 days after the transfer of qualified indications of ownership of the replacement property to the EAT, you must identify the relinquished property in a manner consistent with the principles for deferred exchanges. See Identification requirement earlier under Deferred Exchange.
2. One of the following transfers must take place no later than 180 days after the transfer of qualified indications of ownership of the property to the EAT.
   1. The replacement property is transferred to you (either directly or indirectly through a qualified intermediary, defined earlier under Like-Kind Exchanges Using Qualified Intermediaries).
   2. The relinquished property is transferred to a person other than you or a disqualified person. A disqualified person is either of the following.
      1. Your agent at the time of the transaction. This includes a person who has been your employee, attorney, accountant, investment banker or broker, or real estate agent or broker within the 2-year period before the transfer of the relinquished property.
      2. A person who is related to you or your agent under the rules discussed in chapter 2 under Nondeductible Loss, substituting "10%" for "50%."
3. The combined time period the relinquished property and replacement property are held in the QEAA cannot be longer than 180 days.

Exchange accommodation titleholder (EAT). The EAT must meet all the following requirements.

• Hold qualified indications of ownership (defined next) at all times from the date of acquisition of the property until the property is transferred (as described in (2), earlier).
• Be someone other than you or a disqualified person (as defined in 2(b), earlier).
• Be subject to federal income tax. If the EAT is treated as a partnership or S corporation, more than 90% of its interests or stock must be owned by partners or shareholders who are subject to federal income tax.

Qualified indications of ownership. Qualified indications of ownership are any of the following.

• Legal title to the property.
• Other indications of ownership of the property that are treated as beneficial ownership of the property under principles of commercial law (for example, a contract for deed).
• Interests in an entity that is disregarded as an entity separate from its owner for federal income tax purposes (for example, a single member limited liability company) and that holds either legal title to the property or other indications of ownership.

Other permissible arrangements. Property will not fail to be treated as being held in a QEAA as a result of certain legal or contractual arrangements, regardless of whether the arrangements contain terms that typically would result from arm's-length bargaining between unrelated parties for those arrangements. For a list of those arrangements, see Revenue Procedure 2000-37 in Internal Revenue Bulletin No. 2000-40.

Partially Nontaxable Exchanges

If, in addition to like-kind property, you receive money or unlike property in an exchange on which you realize a gain, you have a partially nontaxable exchange. You are taxed on the gain you realize, but only to the extent of the money and the fair market value of the unlike property you receive.

A loss is never deductible in a nontaxable exchange in which you receive unlike property or cash.

To figure the taxable gain, first determine the fair market value of any unlike property you receive and add it to any money you receive. The total is the maximum gain that can be taxed. Next, figure the gain on the whole exchange as discussed earlier under Gain or Loss From Sales and Exchanges. Your recognized (taxable) gain is the lesser of these two amounts.

Example. You exchange real estate held for investment with an adjusted basis of $8,000 for other real estate you want to hold for investment. The fair market value of the real estate you receive is $10,000. You also receive $1,000 in cash. You paid $500 in exchange expenses. Although the total gain realized on the transaction is $2,500, only $500 ($1,000 cash received minus the $500 exchange expenses) is recognized (included in your income).

Assumption of liabilities. If the other party to a nontaxable exchange assumes any of your liabilities, you will be treated as if you received cash in the amount of the liability. For more information on the assumption of liabilities, see section 357(d) of the Internal Revenue Code.

Example. The facts are the same as in the previous example, except the property you give up is subject to a $3,000 mortgage for which you were personally liable. The other party in the trade has agreed to pay off the mortgage. Figure the gain realized as follows.

FMV of like-kind property received	$10,000
Cash	1,000
Mortgage treated as assumed by other party	3,000
Total received	$14,000
Minus: Exchange expenses	(500)
Amount realized	$13,500
Minus: Adjusted basis of property you transferred	(8,000)
Realized gain	$ 5,500

The realized gain is taxed only up to $3,500, the sum of the cash received ($1,000 - $500 exchange expenses) and the mortgage ($3,000).

Unlike property given up. If, in addition to like-kind property, you give up unlike property, you must recognize gain or loss on the unlike property you give up. The gain or loss is equal to the difference between the fair market value of the unlike property and the adjusted basis of the unlike property.

Example. You exchange stock and real estate you held for investment for real estate you also intend to hold for investment. The stock you transfer has a fair market value of $1,000 and an adjusted basis of $4,000. The real estate you exchange has a fair market value of $19,000 and an adjusted basis of $15,000. The real estate you receive has a fair market value of $20,000. You do not recognize gain on the exchange of the real estate because it qualifies as a nontaxable exchange. However, you must recognize (report on your return) a $3,000 loss on the stock because it is unlike property.

Basis of property received. The total basis for all properties (other than money) you receive in a partially nontaxable exchange is the total adjusted basis of the properties you give up, with the following adjustments.

1. Add both the following amounts.
1. Any additional costs you incur.
2. Any gain you recognize on the exchange.
2. Subtract both the following amounts.
1. Any money you receive.
2. Any loss you recognize on the exchange.

Allocate this basis first to the unlike property, other than money, up to its fair market value on the date of the exchange. The rest is the basis of the like-kind property.

Multiple Property Exchanges

Under the like-kind exchange rules, you must generally make a property-by-property comparison to figure your recognized gain and the basis of the property you receive in the exchange. However, for exchanges of multiple properties, you do not make a property-by-property comparison if you do either of the following.

• Transfer and receive properties in two or more exchange groups.
• Transfer or receive more than one property within a single exchange group.

In these situations, you figure your recognized gain and the basis of the property you receive by comparing the properties within each exchange group.

Exchange groups. Each exchange group consists of properties transferred and received in the exchange that are of like kind or like class. (See Like-Kind Property, earlier.) If property could be included in more than one exchange group, you can include it in any one of those groups. However, the following may not be included in an exchange group.

• Money.
• Stock in trade or other property held primarily for sale.
• Stocks, bonds, notes, or other securities or evidences of debt or interest.
• Interests in a partnership.
• Certificates of trust or beneficial interests.
• Choses in action.

Example. Ben exchanges computer A (asset class 00.12), automobile A (asset class 00.22), and truck A (asset class 00.241) for computer R (asset class 00.12), automobile R (asset class 00.22), truck R (asset class 00.241), and $400. All properties transferred were used in Ben's business. Similarly, all properties received will be used in his business.

The first exchange group consists of computers A and R, the second exchange group consists of automobiles A and R, and the third exchange group consists of trucks A and R.

Treatment of liabilities. Offset all liabilities you assume as part of the exchange against all liabilities of which you are relieved. Offset these liabilities whether they are recourse or nonrecourse and regardless of whether they are secured by or otherwise relate to specific property transferred or received as part of the exchange.

If you assume more liabilities than you are relieved of, allocate the difference among the exchange groups in proportion to the total fair market value of the properties you received in the exchange groups. The difference allocated to each exchange group may not be more than the total fair market value of the properties you received in the exchange group.

The amount allocated to an exchange group reduces the total fair market value of the properties received in that exchange group. This reduction is made in determining whether the exchange group has a surplus or a deficiency. (See Exchange group surplus and deficiency, later.) This reduction is also made in determining whether a residual group is created. (See Residual group, later.)

If you are relieved of more liabilities than you assume, treat the difference as cash, general deposit accounts (other than certificates of deposit), and similar items when making allocations to the residual group, discussed later.

The treatment of liabilities and any differences between amounts you assume and amounts you are relieved of will be the same even if the like-kind exchange treatment applies to only part of a larger transaction. If so, determine the difference in liabilities based on all liabilities you assume or are relieved of as part of the larger transaction.

Example. The facts are the same as in the preceding example. In addition, the fair market value of and liabilities secured by each property are as follows.

	Fair Market Value	Liability
Ben Transfers:
Computer A	$1,500	$ -0-
Automobile A	2,500	500
Truck A	2,000	-0-
Ben Receives:
Computer R	$1,600	$ -0-
Automobile R	3,100	750
Truck R	1,400	250
Cash	400

All liabilities assumed by Ben ($1,000) are offset by all liabilities of which he is relieved ($500), resulting in a difference of $500. The difference is allocated among Ben's exchange groups in proportion to the fair market value of the properties received in the exchange groups as follows.

• $131 ($500 × $1,600 × $6,100) is allocated to the first exchange group (computers A and R). The fair market value of computer R is reduced to $1,469 ($1,600 - $131).
• $254 ($500 × $3,100 × $6,100) is allocated to the second exchange group (automobiles A and R). The fair market value of automobile R is reduced to $2,846 ($3,100 - $254).
• $115 ($500 × $1,400 × $6,100) is allocated to the third exchange group (trucks A and R). The fair market value of truck R is reduced to $1,285 ($1,400 - $115).

In each exchange group, Ben uses the reduced fair market value of the properties received to figure the exchange group's surplus or deficiency and to determine whether a residual group has been created.

Residual group. A residual group is created if the total fair market value of the properties transferred in all exchange groups differs from the total fair market value of the properties received in all exchange groups after taking into account the treatment of liabilities (discussed earlier). The residual group consists of money or other property that has a total fair market value equal to that difference. It consists of either money or other property transferred in the exchange or money or other property received in the exchange, but not both.

Other property includes the following items.

• Stock in trade or other property held primarily for sale.
• Stocks, bonds, notes, or other securities or evidences of debt or interest.
• Interests in a partnership.
• Certificates of trust or beneficial interests.
• Choses in action.

Other property also includes property transferred that is not of a like kind or like class with any property received, and property received that is not of a like kind or like class with any property transferred.

For asset acquisitions occurring after March 15, 2001, money and properties allocated to the residual group are considered to come from the following assets in the following order.

1. Cash and general deposit accounts (including checking and savings accounts but excluding certificates of deposit). Also include here excess liabilities of which you are relieved over the amount of liabilities you assume.
2. Certificates of deposit, U.S. Government securities, foreign currency, and actively traded personal property, including stock and securities.
3. Accounts receivable, other debt instruments, and assets that you mark to market at least annually for federal income tax purposes. However, see section 1.338-6(b)(2)(iii) of the regulations for exceptions that apply to debt instruments issued by persons related to a target corporation, contingent debt instruments, and debt instruments convertible into stock or other property.
4. Property of a kind that would properly be included in inventory if on hand at the end of the tax year or property held by the taxpayer primarily for sale to customers in the ordinary course of business.

Within each category, you can choose which properties to allocate to the residual group. If an asset described in (2), (3), or (4) is includible in more than one category, include it in the lower number category. For example, if an asset is described in both (3) and in (4), include it in (3).

For asset acquisitions occurring after January 5, 2000, and before March 16, 2001, money and properties allocated to the residual group are considered to come from the following assets in the following order.

1. Cash and general deposit accounts (including checking and savings accounts but excluding certificates of deposit).
2. Certificates of deposit, U.S. Government securities, foreign currency, and actively traded personal property, including stock and securities.
3. Accounts receivable, mortgages, and credit card receivables that arose in the ordinary course of business.
4. Property of a kind that would properly be included in inventory if on hand at the end of the tax year or property held by the taxpayer primarily for sale to customers in the ordinary course of business.

Example. Fran exchanges computer A (asset class 00.12) and automobile A (asset class 00.22) for printer B (asset class 00.12), automobile B (asset class 00.22), corporate stock, and $500. Fran used computer A and automobile A in her business and will use printer B and automobile B in her business.

This transaction results in two exchange groups: (1) computer A and printer B, and (2) automobile A and automobile B.

The fair market values of the properties are as follows.

	Fair Market Value
Fran Transfers:
Computer A	$1,000
Automobile A	4,000
Fran Receives:
Automobile B	$2,950
Printer B	800
Corporate Stock	750
Cash	500

Because the total fair market value of the properties transferred in the exchange groups ($5,000) is $1,250 more than the total fair market value of the properties received in the exchange groups ($3,750), there is a residual group in that amount. It consists of the $500 cash and the $750 worth of corporate stock.

Exchange group surplus and deficiency. For each exchange group, you must determine whether there is an "exchange group surplus" or "exchange group deficiency." An exchange group surplus is the total fair market value of the properties received in an exchange group (minus any excess liabilities you assume that are allocated to that exchange group) that is more than the total fair market value of the properties transferred in that exchange group. An exchange group deficiency is the total fair market value of the properties transferred in an exchange group that is more than the total fair market value of the properties received in that exchange group (minus any excess liabilities you assume that are allocated to that exchange group).

Example. Karen exchanges computer A (asset class 00.12) and automobile A (asset class 00.22), both of which she used in her business, for printer B (asset class 00.12) and automobile B (asset class 00.22), both of which she will use in her business. Karen's adjusted basis and the fair market value of the exchanged properties are as follows.

	Adjusted Basis	Fair Market Value
Karen Transfers:
Automobile A	$1,500	$4,000
Computer A	375	1,000
Karen Receives:
Printer B		$2,050
Automobile B		2,950

The first exchange group consists of computer A and printer B. It has an exchange group surplus of $1,050 because the fair market value of printer B ($2,050) is more than the fair market value of computer A ($1,000) by that amount.

The second exchange group consists of automobile A and automobile B. It has an exchange group deficiency of $1,050 because the fair market value of automobile A ($4,000) is more than the fair market value of automobile B ($2,950) by that amount.

Recognized gain. Gain or loss realized for each exchange group and the residual group is the difference between the total fair market value of the transferred properties in that exchange group or residual group and the total adjusted basis of the properties. For each exchange group, recognized gain is the lesser of the gain realized or the exchange group deficiency (if any). Losses are not recognized for an exchange group. The total gain recognized on the exchange of like-kind or like-class properties is the sum of all the gain recognized for each exchange group.

For a residual group, you must recognize the entire gain or loss realized.

For properties you transfer that are not within any exchange group or the residual group, figure realized and recognized gain or loss as explained under Gain or Loss From Sales and Exchanges, earlier.

Example. Based on the facts in the previous example, Karen recognizes gain on the exchange as follows.

For the first exchange group, the gain realized is the fair market value of computer A ($1,000) minus its adjusted basis ($375), or $625. The gain recognized is the lesser of the gain realized ($625) or the exchange group deficiency ($0), or $0.

For the second exchange group, the gain realized is the fair market value of automobile A ($4,000) minus its adjusted basis ($1,500), or $2,500. The gain recognized is the lesser of the gain realized ($2,500) or the exchange group deficiency ($1,050), or $1,050.

The total gain recognized by Karen in the exchange is the sum of the gains recognized with respect to both exchange groups ($0 + $1,050), or $1,050.

Basis of properties received. The total basis of properties received in each exchange group is the sum of the following amounts.

1. The total adjusted basis of the transferred properties within that exchange group.
2. Your recognized gain on the exchange group.
3. The excess liabilities you assume that are allocated to the group.
4. The exchange group surplus (or minus the exchange group deficiency).

You allocate the total basis of each exchange group proportionately to each property received in the exchange group according to the property's fair market value.

The basis of each property received within the residual group (other than money) is equal to its fair market value.

Example. Based on the facts in the two previous examples, the bases of the properties received by Karen in the exchange, printer B and automobile B, are determined in the following manner.

The basis of the property received in the first exchange group is $1,425. This is the sum of the following amounts.

1. Adjusted basis of the property transferred within that exchange group ($375).
2. Gain recognized for that exchange group ($0).
3. Excess liabilities assumed allocated to that exchange group ($0).
4. Exchange group surplus ($1,050).

Because printer B is the only property received within the first exchange group, the entire basis of $1,425 is allocated to printer B.

The basis of the property received in the second exchange group is $1,500. This is figured as follows.

First, add the following amounts.

1. Adjusted basis of the property transferred within that exchange group ($1,500).
2. Gain recognized for that exchange group ($1,050).
3. Excess liabilities assumed allocated to that exchange group ($0).

Then subtract the exchange group deficiency ($1,050).

Because automobile B is the only property received within the second exchange group, the entire basis ($1,500) is allocated to automobile B.

Like-Kind Exchanges Between Related Persons

Special rules apply to like-kind exchanges between related persons. These rules affect both direct and indirect exchanges. Under these rules, if either person disposes of the property within 2 years after the exchange, the exchange is disqualified from nonrecognition treatment. The gain or loss on the original exchange must be recognized as of the date of the later disposition.

Related persons. Under these rules, related persons include, for example, you and a member of your family (spouse, brother, sister, parent, child, etc.), you and a corporation in which you have more than 50% ownership, you and a partnership in which you directly or indirectly own more than a 50% interest of the capital or profits, and two partnerships in which you directly or indirectly own more than 50% of the capital interests or profits.

For more information on related persons, see Nondeductible Loss under Sales and Exchanges Between Related Persons in chapter 2.

Example. You used a panel truck in your house painting business. Your sister used a station wagon in her landscaping business. In December 2000, you exchanged your truck plus $200 for your sister's station wagon. At that time, the fair market value (FMV) of your truck was $7,000 and its adjusted basis was $6,000. The fair market value of your sister's station wagon was $7,200 and its adjusted basis was $1,000. You realized a gain of $1,000 (the $7,200 fair market value of the station wagon minus the $200 you paid minus the $6,000 adjusted basis of the truck). Your sister realized a gain of $6,200 (the $7,000 fair market value of your truck plus the $200 you paid minus the $1,000 adjusted basis of the station wagon).

However, because this was a like-kind exchange, you recognized no gain. Your basis in the station wagon was $6,200 (the $6,000 adjusted basis of the truck plus the $200 you paid). Your sister recognized gain only to the extent of the money she received, $200. Her basis in the truck was $1,000 (the $1,000 adjusted basis of the station wagon minus the $200 received, plus the $200 gain recognized).

In 2001, you sold the station wagon to a third party for $7,000. Because you sold it within 2 years after the exchange, the exchange is disqualified from nonrecognition treatment. On your 2001 tax return, you must report your $1,000 gain on the 2000 exchange. You also report a loss on the sale of $200 (the adjusted basis of the station wagon, $7,200 (its $6,200 basis plus the $1,000 gain recognized) minus the $7,000 realized from the sale).

In addition, your sister must report on her 2001 tax return the $6,000 balance of her gain on the 2000 exchange. Her adjusted basis in the truck is increased to $7,000 (its $1,000 basis plus the $6,000 gain recognized).

Two-year holding period. The 2-year holding period begins on the date of the last transfer of property that was part of the like-kind exchange. If the holder's risk of loss on the property is substantially diminished during any period, however, that period is not counted toward the 2-year holding period. The holder's risk of loss on the property is substantially diminished by any of the following events.

• The holding of a put on the property.
• The holding by another person of a right to acquire the property.
• A short sale or other transaction.

A put is an option that entitles the holder to sell property at a specified price at any time before a specified future date.

A short sale involves property you generally do not own. You borrow the property to deliver to a buyer and, at a later date, buy substantially identical property and deliver it to the lender.

Exceptions to the rules for related persons. The following kinds of property dispositions are excluded from these rules.

• Dispositions due to the death of either related person.
• Involuntary conversions.
• Dispositions if it is established to the satisfaction of the IRS that neither the exchange nor the disposition had as a main purpose the avoidance of federal income tax.

Other Nontaxable Exchanges

The following discussions describe other exchanges that may not be taxable.

Partnership Interests

Exchanges of partnership interests do not qualify as nontaxable exchanges of like-kind property. This applies regardless of whether they are general or limited partnership interests or are interests in the same partnership or different partnerships. However, under certain circumstances the exchange may be treated as a tax-free contribution of property to a partnership. See Contribution of Property in Publication 541, Partnerships.

An interest in a partnership that has a valid choice in effect under section 761(a) of the Internal Revenue Code to be excluded from all the rules of Subchapter K of the Code is treated as an interest in each of the partnership assets and not as a partnership interest. See Exclusion From Partnership Rules in Publication 541.

U.S. Treasury Notes or Bonds

Certain issues of U.S. Treasury obligations may be exchanged for certain other issues designated by the Secretary of the Treasury with no gain or loss recognized on the exchange. See U.S. Treasury Bills, Notes, and Bonds under Interest Income in Publication 550 for more information on the tax treatment of income from these investments.

For other information on these notes and bonds, call the Bureau of the Public Debt at 1 (304) 480-7936, or write to the following address. Bureau of the Public Debt Attn: Marketable Assistance Branch P.O. Box 426 Parkersburg, WV 26106

Or, on the Internet, visit: www.publicdebt.treas.gov

Insurance Policies and Annuities

No gain or loss is recognized if you make any of the following exchanges.

• A life insurance contract for another or for an endowment or annuity contract.
• An endowment contract for an annuity contract or for another endowment contract providing for regular payments beginning at a date not later than the beginning date under the old contract.
• One annuity contract for another if the insured or annuitant remains the same.

If you realize a gain on the exchange of an endowment contract or annuity contract for a life insurance contract or an exchange of an annuity contract for an endowment contract, you must recognize the gain.

For information on transfers and rollovers of employer-provided annuities, see Publication 575, Pension and Annuity Income, or Publication 571, Tax-Sheltered Annuity Plans (403(b) Plans).

Cash received. The nonrecognition and nontaxable transfer rules do not apply to a rollover in which you receive cash proceeds from the surrender of one policy and invest the cash in another policy. However, you can treat a cash distribution and reinvestment as meeting the nonrecognition or nontaxable transfer rules if all the following requirements are met.

1. When you receive the distribution, the insurance company that issued the policy or contract is subject to a rehabilitation, conservatorship, insolvency, or similar state proceeding.
2. You withdraw all amounts to which you are entitled or the maximum permitted under the state proceeding.
3. You reinvest the distribution within 60 days after receipt in a single policy or contract issued by another insurance company or in a single custodial account.
4. You assign all rights to future distributions to the new issuer for investment in the new policy or contract if the distribution was restricted by the state proceeding.
5. You would have qualified under the nonrecognition or nontaxable transfer rules if you had exchanged the affected policy or contract for the new one.

If you do not reinvest all of the cash distribution, the rules for partially nontaxable exchanges, discussed earlier, apply.

In addition to meeting these five requirements, you must do both the following.

1. Give to the issuer of the new policy or contract a statement that includes all the following information.
1. The gross amount of cash distributed.
2. The amount reinvested.
3. Your investment in the affected policy or contract on the date of the initial cash distribution.
2. Attach the following items to your timely filed tax return for the year of the initial distribution.
1. A statement titled "Election under Rev. Proc. 92-44" that includes the name of the issuer and the policy number (or similar identifying number) of the new policy or contract.
2. A copy of the statement given to the issuer of the new policy or contract.

Property Exchanged for Stock

If you transfer property to a corporation in exchange for stock in that corporation (other than nonqualified preferred stock, described later), and immediately afterward you are in control of the corporation, the exchange is usually not taxable. This rule applies both to individuals and to groups who transfer property to a corporation. It does not apply in the following situations.

• The corporation is an investment company.
• You transfer the property in a bankruptcy or similar proceeding in exchange for stock used to pay creditors.
• The stock is received in exchange for the corporation's debt (other than a security) or for interest on the corporation's debt (including a security) that accrued while you held the debt.

Control of a corporation. To be in control of a corporation, you or your group of transferors must own, immediately after the exchange, at least 80% of the total combined voting power of all classes of stock entitled to vote and at least 80% of the outstanding shares of each class of nonvoting stock.

Example 1. You and Bill Jones buy property for $100,000. You both organize a corporation when the property has a fair market value of $300,000. You transfer the property to the corporation for all its authorized capital stock, which has a par value of $300,000. No gain is recognized by you, Bill, or the corporation.

Example 2. You and Bill transfer the property with a basis of $100,000 to a corporation in exchange for stock with a fair market value of $300,000. This represents only 75% of each class of stock of the corporation. The other 25% was already issued to someone else. You and Bill recognize a taxable gain of $200,000 on the transaction.

Services rendered. The term property does not include services rendered or to be rendered to the issuing corporation. The value of stock received for services is income to the recipient.

Example. You transfer property worth $35,000 and render services valued at $3,000 to a corporation in exchange for stock valued at $38,000. Right after the exchange, you own 85% of the outstanding stock. No gain is recognized on the exchange of property. However, you recognize ordinary income of $3,000 as payment for services you rendered to the corporation.

Property of relatively small value. The term property does not include property of a relatively small value when it is compared to the value of stock and securities already owned or to be received for services by the transferor if the main purpose of the transfer is to qualify for the nonrecognition of gain or loss by other transferors.

Property transferred will not be considered to be of relatively small value if its fair market value is at least 10% of the fair market value of the stock and securities already owned or to be received for services by the transferor.

Stock received in disproportion to property transferred. If a group of transferors exchange property for corporate stock, each transferor does not have to receive stock in proportion to his or her interest in the property transferred. If a disproportionate transfer takes place, it will be treated for tax purposes in accordance with its true nature. It may be treated as if the stock were first received in proportion and then some of it used to make gifts, pay compensation for services, or satisfy the transferor's obligations.

Money or other property received. If, in an otherwise nontaxable exchange of property for corporate stock, you also receive money or property other than stock, you may have to recognize gain. You must recognize gain only up to the amount of money plus the fair market value of the other property you receive. The rules for figuring the recognized gain in this situation generally follow those for a partially nontaxable exchange discussed earlier under Like-Kind Exchanges. If the property you give up includes depreciable property, the recognized gain may have to be reported as ordinary income from depreciation. See chapter 3. No loss is recognized.

Nonqualified preferred stock. Nonqualified preferred stock is treated as property other than stock. Generally, it is preferred stock with any of the following features.

• The holder has the right to require the issuer or a related person to redeem or buy the stock.
• The issuer or a related person is required to redeem or buy the stock.
• The issuer or a related person has the right to redeem or buy the stock and, on the issue date, it is more likely than not that the right will be exercised.
• The dividend rate on the stock varies with reference to interest rates, commodity prices, or similar indices.

For a detailed definition of nonqualified preferred stock, see section 351(g)(2) of the Internal Revenue Code.

Liabilities. If the corporation assumes your liabilities, the exchange is not generally treated as if you received money or other property. There are two exceptions to this treatment.

• If the liabilities the corporation assumes are more than your adjusted basis in the property you transfer, gain is recognized up to the difference. However, if the liabilities assumed give rise to a deduction when paid, such as a trade account payable or interest, no gain is recognized.
• If there is no good business reason for the corporation to assume your liabilities, or if your main purpose in the exchange is to avoid federal income tax, the assumption is treated as if you received money in the amount of the liabilities.

For more information on the assumption of liabilities, see section 357(d) of the Internal Revenue Code.

Example. You transfer property to a corporation for stock. Immediately after the transfer, you control the corporation. You also receive $10,000 in the exchange. Your adjusted basis in the transferred property is $20,000. The stock you receive has a fair market value (FMV) of $16,000. The corporation also assumes a $5,000 mortgage on the property for which you are personally liable. Gain is realized as follows.

FMV of stock received	$16,000
Cash received	10,000
Liability assumed by corporation	5,000
Total received	$31,000
Minus: Adjusted basis of property transferred	20,000
Realized gain	$11,000

The liability assumed is not treated as money or other property. The recognized gain is limited to $10,000, the cash received.

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